Thursday, March 12, 2009

Some Credit Crisis Conjectures

From Douglas Diamond and Raghuram G. Rajan in their recent NBER working paper (ungated version here). I have been suffering from crisis overload and not posting much about it lately, but this piece is an extremely readable, clear, non-technical and interesting overview of the underlying causes of the crisis and it also contains some interesting ideas about why we continue to have a credit crunch and what the government can do about it.

They address one element of the crisis that I have found very weird. Securitization is a way to package up and sell off risk. Yet tons of banks (originators) held on to mortgage backed securities. Here's their take:

Given that originators would have understood the deterioration of the underlying quality of mortgages, it is surprising that they held on to so many of the mortgage-backed securities (MBS)in their own portfolios. These were not just the low-rated equity portions that would have signaled their faith in the packages, but also the high-rated tranches that found a ready marketaround the world. The amounts of MBS held seemed too high to be purely inventory. Some holdings could have been portions of the package they could not sell, but then this would not explain why banks held on to AAA-rated securities, which seemed to be the most highly demanded of mortgagebacked securities. The real answer seems to be that bankers thought these securities were worthwhile investments, despite their risk. Investment in MBS seemed to be part of a culture of excessive risk taking that had overtaken banks (see Raghuram G. Rajan, 2005; and Anil K. Kashyap, Raghuram G. Rajan, and Jeremy C. Stein, 2008). A key factor contributing to this culture is that, over short periods of time, it is very hard, especially in the case of new products, to tell whether a financial manager is generating true excess returns adjusting for risk, or whether the current returns are simply compensation for arisk that has not yet shown itself but that will eventually materialize.